Commodity Funds Influence Prices

Normally I don't like to write about issues I can't change. One of those issues, and a hot topic throughout the country, is the influence of commodity funds and index funds on commodity prices. Generally, people who talk most about these subjects at the coffee shop usually know the least.

To begin with, there is a big difference between a commodity fund and an index fund, and the impact each type has on a market.

Index funds have only been around for a few years and were created for the benefit of investors who only want to be long “own” commodities. The viewpoint is that investing in a commodity index fund is an inflation hedge and also an opportunity to take advantage of China's insatiable appetite for world commodities. They are always long — never short.

Standard commodity funds, on the other hand, can be long, short or spread — they can do almost anything in a market as outlined in their prospectus. Some specialize in financials while others are in energy and only a few specialize in ag commodities.

There is little question that the influence of commodity funds on commodity prices in the short term has increased substantially in the last two years.

The chart and table below give a vivid example why the influence of commodity funds on prices has exploded. As this goes to press, the data at year end for 2005 was not yet available. You'll note on the chart, however, the total dollars in commodity funds actually showed a slight decline during 2005. General commodity funds had a disappointing 2005 in terms of return, which weighed on the total dollar value of commodity funds.

The growth since 2000 has been explosive and was certainly steady to strong from 1990 to 2000. In 1990 only about $10 billion was attributed to commodity funds. By 2000 that number had risen to more than $30 billion and the number will soon be near $140 billion.

More important than this number, however, is the change in structure for position size that has occurred in the last year. Note on the table that prior to June 10, 2005, the largest position a commodity fund could take (or an individual speculator — all farmers qualify) was 9,000 contracts of corn (45 million bushels). On June 10 that number was increased to 15,500 contracts and on Dec. 10 the number was increased again to 22,000 contracts, or 110 million bushels. So in the last year the position size any individual trader or fund could take in the corn market has more than doubled. The position size in soybeans has gone from 27.5 million bushels to 50 million bushels.

With this huge increase in position size, many of the larger commodity funds who were not players in ag commodities can now justify trading them.

The reason the very large funds couldn't trade before is simple. Let's assume you're a manager of one of the larger funds with $4 billion under management. Prior to June 10 of last year, if you held to a limit position of 45 million bushels and the corn market moved by 20¢ you made or lost $9 million. On $4 billion in assets that's only a .2% gain or loss. Why bother?

Now increase the position size to 110 million, in which case a 20¢ move would be $22 million. Now the return is up to at least .5%. This is starting to attract more players to the market, which will eventually lead to more dollars in the market and increased volatility.

Parting Thoughts

Supplies are enormous in both corn and soybeans this year. As this goes to press, next year's soybeans are trading at nearly $6.50/bu. in the futures market and corn is more than $2.50. Past price relationships with ending supplies would indicate that these markets are already overpriced. But with the help of commodity funds, they may become even more overpriced.

Last year's peak in the markets came early in the summer. With extremely large supplies this year, my best guess is the peak will come earlier. Be prepared to take advantage of price rallies prior to planting this year's crop. Some of your best marketing opportunities could well occur before planting.

Richard A. Brock is president of Brock Associates, a farm market advisory firm, and publisher ofThe Brock Report. For a trial subscription and information on Brock services, call 800-558-3431 or visitwww.brockreport.com.